Goodwill, Not So Good AnymoreBloombergQuintOpinion
With the Finance Act, 2021, dust has now settled on the long-standing litigation and judicial debate on whether depreciation on goodwill is deductible while computing taxable business profits – the conclusion being in the negative.
Previously, the Supreme Court in the case of Smifs Securities Ltd. decided on the allowability of depreciation on goodwill regarding it as "any other business or commercial rights of similar nature" and therefore bringing it within the meaning of intangible assets in Section 32 of The Income-tax Act, 1961. However, the matter continued to be contested subsequently. The tax law has now been amended to state that goodwill (including existing goodwill) of a business or profession will not be considered as a depreciable asset and depreciation on goodwill of a business or profession would not be allowed as a tax deduction. In case of goodwill of an acquired business (purchased goodwill), the purchase price of the goodwill (adjusted for any previously claimed depreciation) will continue to be considered as cost of acquisition for the purpose of computation of capital gains on sale of the underlying business.
In reaching its decision, the central government in its Memorandum explaining the provisions of the Finance Bill, 2021 has rationalised that goodwill, in general, is not a depreciable asset and in fact depending upon how the business runs; goodwill may see appreciation or in the alternative no depreciation to its value. Accordingly, there may not be a justification of depreciation on goodwill in the manner there is a need to provide for depreciation in case of other intangible assets or plant and machinery.
The International Perspective
It is interesting to note that global accounting standard setters, both the International Accounting Standards Board and Financial Accounting Standards Board are continuing deliberations in their latest proposals as to whether goodwill is a wasting asset and therefore to be amortised or it has a life that is indefinite consequently not to be amortised but only impaired when there is a loss in the value of the related business. However, with the Finance Act, 2021, in India, we have moved ahead and closed this debate, at least from a tax perspective, that goodwill shall not be depreciated.
Now let us see how this may impact entities preparing their March 31, 2021 financial statements and what stakeholders can expect from those entities that have tax deductible goodwill.
The implications of this amendment can be quite significant and are likely to negatively impact net income, cash flows and net worth as follows:
Increased current tax expense as tax amortisation of goodwill will not be deductible;
Increased tax cash outflows and consequently lower operating cash flows;
Entities may have to evaluate the provisions related to interest expense on taxes, as the previous advance tax payments during the year ended March 2021 would not have considered the impact of such amendment disallowing tax benefit of goodwill depreciation; and
Finally, certain entities with large tax deductible goodwill balances may have to recognise a material non-cash deferred tax expense/charge reflecting potentially the loss of the tax shield embodying future tax depreciation that would have otherwise been available to the entity absent this amendment.
Impact On Net Income, Net Worth
The first three items are easier to decipher, let us try and understand the fourth item in some detail, which is important and may possibly reduce reported net income and net worth of certain entities.
Under IndAS, for financial reporting purposes, goodwill of a business is not amortised, instead it is tested for impairment at least annually. If the fair value (or Value-In-Use) of the business incorporating such goodwill declines below its reported carrying amount, then there is an impairment charge to be recognised in profit and loss. However, prior to this Finance Act, 2021 amendment, certain entities may have claimed tax benefit of depreciation on purchased goodwill for tax purposes, which in turn would have resulted in recognition of a deferred tax liability.
Simply put, a deferred tax liability would have been recognised for the amount by which the book base of goodwill exceeds its tax base – i.e. for that portion of goodwill that was being consumed for tax purposes and causing a lower current tax expense.
Now upon the tax law amendment, since no future tax depreciation on goodwill will be available, the loss of such tax shield on the value of goodwill could result in additional deferred tax expense and liability, since the tax base of purchased goodwill is expected to be recovered through use becomes zero. Such deferred tax expense would be immediately recognised in the profit and loss statement resulting in reduction of net income and net worth.
Since, these tax law changes have occurred subsequent to the business acquisition that would have generated the tax deductible goodwill, the initial recognition exception for deferred tax liability under IndAS does not apply.
The impact of the tax law amendment is explained by way of an illustration:
An entity purchased a business on April 1, 2019 and recognised goodwill of Rs 5,000, which is deductible for tax purposes at 20% and the tax rate on income is 25%.
As noted below, due to the tax law amendment, the entity will recognise additional Rs 1,000 of deferred tax expense and liability during the year March 31, 2021.
Considering the above, entities should carefully evaluate the impact of this tax law amendment, their judgment around the expected manner of recovery of goodwill (whether through use or sale) and appropriately explain the financial impact of this amendment in their financial statements and results. Going forward, this will surely impact valuation and related considerations involving future corporate restructurings, mergers and acquisitions.
Sumit Seth is a chartered accountant. Views expressed are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.